Tuesday, 29 April 2014

What does the now sustained recovery in the UK and the still
tentative signs of recovery in the Eurozone tell us? According to some on the
right, it says all is good in the world, austerity has been successful and we
need to stay the course. According to some on the left, the recovery is not real, and anyway it is all because there
are more people, or because of a house price bubble.

First austerity. As I have said many times, the current recovery tells us
nothing about austerity. In the UK austerity helped delay the recovery by three
years. We can argue about how much of the stagnation of 2011 and 2012 was due
to UK austerity and how much to the Eurozone (austerity somewhere else), but no
serious economist would argue with the statement that both played a significant
part in delaying the recovery. That is why I wrote this over a year ago.

In the Eurozone austerity helped create a second recession.
Here we can argue about the relative contributions of fiscal policy and inept
monetary policy, but again no serious economist would disagree that austerity
played a major role. Model based estimates suggest Eurozone GDP was around 4%
lower in 2013 as a result of fiscal consolidation, and this restrictive fiscal
policy was not confined to the periphery.

In the UK austerity was put on hold in 2012 and 2013, which
helped allow the recovery in 2013 (see my April Fools day post or this from Jonathan Portes). However suspending
austerity did not create the recovery, which was mainly down to lower consumer saving. This reduction
in saving may have happened anyway, but both Funding for Lending and Help to
Buy will have lent a helping hand. In the Eurozone austerity has continued.
That will be a drag on growth, but it alone is not enough to prevent a recovery
as consumers rebalance and monetary conditions in periphery countries ease a
little.

What about the counter argument that the recovery is not real,
or not sustainable. In some ways this rhetoric is worse than the ‘austerity
works’ line: it is also wrong, but it is much less likely to succeed as
rhetoric. The fact that growth in output per person (GDP per capita) is less
impressive that GDP growth alone does not detract from the recovery because, in
a demand led recession, population growth does not automatically cause GDP
growth. Recoveries are often led by consumers, but as long as investment
follows on and average incomes begin to rise then a recovery will become
sustainable. The rhetoric will not work because, despite the unequal and uneven
nature of the recovery, many
peopledo feel more optimistic now than two years ago. It is much better for critics of the government to focus
on the ‘wasted years’ of 2010-2012, and on the fall in median incomes (pdf) over the last five
years. If they want economic issues for today and tomorrow, focus on
inequality.

Does this mean that the macroeconomic debate (as opposed to the
political debate) over fiscal policy is over? Here we should go back to basics.
Tightening fiscal policy reduces output, and fiscal stimulus increases output,
when interest rates are at their zero lower bound. So until interest rates
start rising, austerity will still be a drag on growth. The macroeconomics says
recovery could be quicker without austerity. But from a practical policy point
of view, the influence of this basic logic on what politicians do seems as
remote as ever.

So for me the interesting question on austerity has changed.
Although it is occasionally necessary to go over the macroeconomic logic yet
again to counter the rhetoric I discuss above, what I find more interesting is
why policymakers did the wrong thing from 2010 onwards, and what lessons for
the future that implies. Was it all an unfortunate consequence of Greek profligacy?
Is it down to the influence of the financial sector,
and is this a result of mistaken beliefs or vested interests? How do we avoid
this happening again? One obvious answer is that we must start the next
liquidity trap recession with lower levels of public debt. But even if we did,
is that going to stop those ‘close to the markets’ insisting on the dangers of
the large deficits and rising debt that are the inevitable result of a
recession, and then go on to insist that we need fiscal contraction to avoid a funding crisis? If
the answer is no, how can we immunise politicians from such calls?

Of course, just because the recovery and its development tells
us little useful about austerity does not mean it is uninteresting - at least
for a macroeconomist. For me a really big question for the next year or two is
what will happen to inflation, particularly in the US and UK. This has not
always been the case. From the start of the recession until recently consumer
price inflation has been a misleading distraction. One of the clear lessons
from recent history is that a focus on consumer price inflation when there are
various temporary supply side shocks is dangerous. It led the ECB to raise
rates just before a recession, and it almost led to higher rates in the UK. Monetary
policy makers really should reflect on why they were distracted in this way.

In the absence of similar distractions in the future, inflation
should become a better indicator of just how fast the recovery could
potentially be - of how much spare capacity there is available. Yet the exact
relationship between this spare capacity and inflation remains mysterious. Most
theories say that inflation should remain below target if the economy is below
trend, but should inflation be rising or falling? There are some (old and new) theories that suggest that inflation
could become disinflation even though the economy is growing reasonably well.
Given this uncertainty, for a macroeconomist what happens to inflation over the
next year or two will be really interesting.

To sum up, the recovery is welcome: it is not an illusion, but
neither does it atone for the sins of the past. Above all else, it must not
lead to complacency. We have still a long way to go to repair all the damage
caused by the recession. Even when that has been done, the problems that led to the financial crisis have not been fixed. With inflation targets still at 2%, and
perverse fiscal responses, we remain dangerously vulnerable to any future large
negative demand shock.

Friday, 25 April 2014

Thank you for sending your paper ‘National Debt in a Neoclassical Growth
Model’ to the American Economic Review. The paper has now been read by two
referees, and I’m afraid the news is not good.

Referee A raises a fundamental objection. Your model has a two
period structure, where agents work in the first period but do not work in the
second. This assumption is simply stated in one paragraph on your page 2, but
is not justified in any way. In that sense it appears entirely ad hoc.
Furthermore, as referee A stresses, it appears to contradict (is internally
inconsistent with) another fundamental part of you model, which is that agents
attempt to smooth consumption over time. The referee is quite happy with that
assumption, as it clearly comes from standard postulates about the utility of the
consumption of goods. Yet why should these postulates not also apply to the
consumption of leisure? As the referee points out, if agents tried to smooth
leisure in the same way as they smoothed consumption, there would not be any
‘retirement’. As this concern strikes at the heart of your model, it is
troubling.

Referee B raised rather different issues. They pointed out that
the model implies a constant interest rate that is only a function of the
population growth rate. The model therefore makes a clear prediction, but as
the referee points out interest rates have fallen in this country over
the last two decades, without any matching declines in the population growth
rate. So the model has been clearly falsified by events, and therefore cannot
be the basis of any meaningful discussion of the impact of national debt. The
referee is also concerned that you failed to locate your analysis within an
ontological discussion of the open rather than closed nature of the social realm,
which makes your deductivist and formalist reasoning about socially constructed
variables problematic, to say the least.

I am therefore very sorry to inform you that we will be unable
to publish your paper. Referee A did make a number of helpful suggestions about
how ‘retirement’ could be microfounded, and I am sure you will find the
extensive reading list referee B provided on economic methodology helpful in
any future work.

My apologies to Nick
Rowe, whose post gave me the idea. I actually think asking
the question why we have retirement is revealing, but writing the above was
easier than attempting an answer. (And I also think economic methodology is
important!)

Thursday, 24 April 2014

I read the Manchester Post-Crash Economics Society’s (PCES) critique of economics education in the UK with
a bewildering mixture of emotions. (Claire Jones has a short FT summary here.) It is eloquently and intelligently
written, but I believe in some respects fundamentally misguided. It is
indicative of a failure of mainstream economics education, but not (as it
thinks) a failure of mainstream economics. Yet even after all these years, it
is a position I can empathise with.

At its heart the critique is an appeal for plurality in
economics. Rather than pretend that there is one right way to do economics
(what the critique calls neoclassical), the critique says we should recognise
that there are many alternative perspectives which have significant worth (and
which therefore undergraduates should have significant exposure to). These
alternative perspectives have become marginalised within economics over the
last few decades, and the critique suggests that the financial crisis is
evidence that this process should be reversed. This is not an unusual
complaint, and I hear it frequently from those working in other social sciences.

Let me first say what I agree with here. Students should
certainly be shown something of heterodox (non-mainstream) thought. I’d like to
think that if we taught economics to
undergraduates as a more problem solving discipline, with less emphasis on its
axiomatic/deductive structure, that would become easier. We should certainly get more economic history in
there, and again that would be easier with a problem solving approach.

What I disagree with strongly is that the current dominance of
mainstream economics should be reversed, and that we should go back to ‘schools
of thought’ economics. There are three reasons for this.

●
Of course mainstream theory can be conservative. It has
been used by some to support a particular ideology. I complain a lot about
both. But the most important reason mainstream economics has become dominant is
not because of these things, but because it has proved far more useful than all of its heterodox
alternatives put together. I agree with Roger Farmer here: economics is a science. Its response to
data and events may be slow compared to the normal sciences, for obvious
reasons, but it is progressive. I cannot see any fundamental barriers to its
continuing development.

●
This is because mainstream economics can be remarkably
flexible. One of the sad things about the way economics is often taught is that
students do not see much of the interesting stuff that is going on in both
micro and macro, and instead just learn what the discipline looked like 50
years ago.

Let me give one example. Students get taught that under perfect
competition the wage is equal to the marginal product of labour. If that was
all there was to say, then you might indeed believe that economics was just a
means of excusing current levels of executive pay or arguing against the
minimum wage. But instead it is just the start of what economics has to say.
Read Alan Manning, who argues that because firms generally set wages
and changing jobs is costly, monopsony is the more relevant default model.
Read the Piketty et al paper I referenced here which talks about rent seeking by
executives, and how cutting top rates of tax encouraged this rent seeking.
These are powerful and effective critiques of marginal productivity theory.

●
At first reading, heterodox writers can seem like a
breath of fresh air, because they are more holistic and often less formalist.
But while many complain, with some justice, that mainstream economics can be resistant
of radical ideas, I have personally found at least as much intolerance on the
other side. Some heterodox economists appear to reject almost everything that is
mainstream, which is frankly just silly.

I think there may be a particular problem for students who are
exercised by what they see as economic injustices around them. Economics in its
studied neutrality can appear indifferent to that. It is natural for those who
take an anti-establishment, left wing view to react to this perceived
indifference by asking for revolution rather than evolution, by looking for a
new paradigm. Perhaps those on the right, who may be happier with the status
quo, find it easier to work within the mainstream, and use it to their own
advantage. Yet any discipline where a utilitarian view is routine, and where diminishing marginal utility is standard, can
hardly be described as inherently biased towards the status quo.

I think it is true that economics as a discipline has tried too
hard to emphasise that it is an objective, politically neutral discipline,
thereby underplaying value judgements when it makes them. Worse still,
sometimes heavily value laden ideas like the importance of Pareto optimality
are portrayed as being value neutral, which is clearly nonsense (see above).
Yet the idea that it should be possible to build a science of human behaviour
which is independent of ideology or politics is a noble ideal, and one which
has been partly achieved. We may need (and are getting)
more political economy, in the sense of recognising that economics works
alongside and interacts with social and political forces, but I do not think we
need more partisan economics.

Let me get personal. Over the last few years, I have been in
charge of a macroeconomics course at Oxford. For better or worse, if past
evidence is anything to go by, one or two of those taking this
course will end up helping run the economy. There is so much important
mainstream theory that needs to be covered in that course, because it
is theory that is essential to trying to understand what is currently going on
in the world. At its core is Keynesian theory, which has proved its worth since
the recession. (Interest rates didn’t rise because of all that government debt,
inflation didn’t take off because of all the money that has been created, and
austerity did delay the recovery.) It would be a great step backwards if I had
to stop teaching part of that, and instead teach Austrian or Marxian views
about the macroeconomy, or still worse spend time worrying about what Keynes
really meant. I would much rather a future Chancellor, Prime Minister, or
advisor to either, remembered from their undergraduate degree that mainstream
theory said austerity was contractionary, rather than ‘well it all depends on
whether you are a Keynesian or an Austrian’.

None of this implies that there are not large gaps in the
discipline, large elements that will not stand the test of time, and that there
is much still to be done. But I agree with Diane Coyle (about economics, if not DSGE)
that “the Naked Emperor needs to be reclothed rather than dethroned”. New ideas
could perhaps come from heterodox thought, although I suspect that they are
more likely to come from other social science disciplines. But they will be
developed within the mainstream, leading to the evolution of mainstream thought.
If students want to change the world, I think they are much more likely to do
this by working within mainstream economics than heterodox thought.

Tuesday, 22 April 2014

I was pleased to see that David Blanchflower and Adam Posen
have advocated using wage inflation as an intermediate target in their analysis of labour market slack in the US. Specifically
they say

“Our results also point towards using wage inflation as an
additional intermediate target for monetary policy by the FOMC, paralleling on
the real activity side the de facto inflation targets on the price stability
side.”

I have periodically argued for wage inflation targets in the
case of the UK, but both their and my arguments are universal.

My own argument for targeting wage inflation has been a
combination of theory and practicality. As I have often pointed out, there are good theoretical
arguments for targeting alternative measures of inflation besides consumer
prices. The way macroeconomists usually measure the cost of inflation nowadays
is to score the distortion to relative prices created by the combination of
general inflation and the fact that different prices are set at different
times. The ‘ideal’ price index to target would be one that gave a higher weight
to prices that changed infrequently, and a low weight to those that were
changed often. Wages are just another price in this context, and they are
changed infrequently.

The practical argument is that if we had been targeting wage
inflation over the last few years, monetary policy would have worried less
about the temporary inflation induced by shocks such as commodity price
increases or sales taxes. Here is a chart of recent and expected wage inflation
(compensation per employee) from the OECD.

In normal times we would expect 2% price inflation to be
associated with something like 4% wage inflation because of productivity
growth. Wage inflation has not come close to that number in recent years in the
UK, US or the Eurozone. It is difficult to see how the ECB could have raised
interest rates in 2011 - as they did - if they had had wage inflation as an
intermediate target.

The argument put forward by Blanchflower and Posen is rather
different, because they associate wage inflation with the real side of the dual
mandate in the US. To quote:

“wage inflation should be considered as the primary target of
FOMC policy with respect to the employment stabilization side of the Fed’s dual
mandate, at least for now. Unlike unemployment, the rate of wage inflation
requires less judgment and is subject to less distortion by such factors as
inactivity. At least four of the labor markets measures that Yellen cites as
worth monitoring- unemployment, under-employment of part-timers, long-term
unemployment, and participation rate- reveal their non-structural component by
their influence on wage growth. And that is what the Fed should be trying to
stabilize along with prices.”

To paraphrase, unemployment (or anything similar) can become
distorted as a measure of labour market slack, but wage inflation is a good
indicator of the true state of the labour market.

I would add one final point. The spectre that seems to haunt
central bankers is the inflation of the 1970s. That has to be avoided at all
costs. Yet the 1970s was associated with what was called a wage-price spiral:
both price inflation and wage inflation rising rapidly, and a feeling that this
was a contest between workers and firms that neither could win, but where society
was a loser. If we want to avoid a wage-price spiral happening again, it is
only logical that we look at wages as well as prices.

There are probably a number of reasons why bank leverage (the
amount of lending banks do in proportion to their capital) increased rapidly in the 00s: reduced
regulation, underestimation of systemic risk as a result of the Great
Moderation, a search for yield when interest rates were low, simple greed. Bank
profits rose, and so did the incomes of those working for them. However the
consequence of excessive leverage was inevitable: a major global financial
crisis. Banks had to be bailed out using public funds.

This produced a large negative demand shock which monetary
policy was not able to counteract, because nominal interest rates fell to zero.
In the US and UK governments undertook substantial fiscal stimulus to dampen
the recession, but this, the recession and bank bailouts raised levels of
public debt. As Reinhart and Rogoff show, credit booms and bust generally lead
to public debt crises.

In recent research Alan Taylor and co-authors go
further. They show that recessions are deeper and more prolonged if they are
accompanied by a financial crisis, they are deeper and longer still if that
financial crisis is preceded by a credit boom, and finally “the path of
recovery is worse still when a credit-fueled crisis coincides with elevated
public debt levels”.

Yet we need to be careful to avoid seeing some kind of
inevitability here. For a start, following this recession there was no public
debt crisis outside of the Eurozone. There was widespread concern about debt,
which led to fiscal contraction, but no crisis. Prompt action that avoided a
crisis, some would say. But we should be suspicious here. As Paul Krugman notes, this concern about debt was largely
down to “the influence of the Very Serious People, whose views on economics
tend in turn to be driven largely by the financial industry”. This financial
industry got some of its economics seriously wrong, as Krugman notes here. I’ve also suggested that there may be self interest at
play: finance needed to change the story from bank regulation. Even more
cynically big banks needed lower debt levels to make their next bailout
credible, so it could carry on enjoying high wages via an implicit subsidy. So, outside the Eurozone,
was concern about debt real, imagined or manufactured?

In the Eurozone there was a debt crisis. Everyone agrees the
Greek government had overspent. But this crisis could have been resolved fairly quickly, if
the Greek government had immediately defaulted on its debt, and the ECB had
offered unlimited support for other solvent governments. However Greek default
would have led to large losses for European banks, and possibly created a
second financial crisis. As a result, default was initially resisted in Greece
(to allow banks time to minimise the damage) and avoided elsewhere, and instead
draconian austerity policies were imposed in the Eurozone periphery.

In a very direct sense, banks created austerity in the
Eurozone. If that sounds like an outlandish conspiracy theory to you, here is Philippe Legrain, former advisor to
the European Commission President:

“The primary cause of the crisis was the reckless lending of
German and French banks (both directly and through local banks) to Spanish and
Irish homeowners, Portuguese consumers and the Greek government. But by
insisting that Greek, Irish, Portuguese and Spanish taxpayers pay in full for
those banks’ mistakes, Chancellor Angela Merkel’s government and its
handmaidens in Brussels have systematically privileged the interests of German
and French banks over those of euro zone citizens.”

Furthermore we know the political influence of the banks is
huge: here I talk about the US and UK, but it seems
unlikely that this does not also apply to the Eurozone.So in the Eurozone we had a
second recession, which was the direct result of austerity. Eventually the ECB
agreed to (in principle) provide unlimited support to solvent Eurozone
governments, but not before austerity had been hardwired in the form of a new
fiscal compact. Changes in bank regulation have fallen far short of what is required to avoid another
crisis, as banks warned that increasing regulation would restrict their ability
to lend, and therefore prolong the recession. The earnings of bank employees
quickly recovered and resumed their rapid rise (see here, or here).

Rather than seeing the financial crisis and austerity as two
essentially separate stories, the needs and influence of the banks connect the
two. Now there are many things missing from this story that I am sure are
important, such as opportunism from those who wanted a smaller state. However
one rather neat feature of this account is that it requires very few ‘exogenous
shocks’. Indeed you could even argue that something like Greece was bound to
happen somewhere, and so even this was endogenous to the story. As Mark Blyth writes, “what starts with the banks ends with
the banks”.

Monday, 21 April 2014

We are all used to seeing graphs of house price to income
ratios. Here is Nationwide’s first time buyer house price to
earnings ratio for the UK and London.

UK First time buyer house prices relative to earnings: source Nationwide

Housing is becoming more and more unaffordable for first time
buyers. Yet prices are currently booming (at least in London), and demand is so
high estate agents are apparently now holding mass viewings to cope.
In the UK the media now routinely call this a bubble, and the term ‘super
bubble’ is now being used. London may be a bit unusual (see this
extraordinary research), but it can also be a leading indicator for UK prices
in general.

Bubbles are where prices move further and further away from
their fundamental value, simply because everyone expects prices to continue to
rise. One of the earliest and most famous bubbles involved
tulip bulbs in the Netherlands in 1637. Yet that bubble lasted less than a
year. The dot-com bubble lasted two or three years. If
you think there should be some underlying constant value for the house price to
income ratio, then this UK housing bubble has been going on for much longer
than that. Instead of being pricked by the 2009 recession, it merely seems to
have paused for breath.

Yet does it make sense to compare house prices (the price of an
asset) to average earnings or incomes? A more natural ratio would be the ratio
of rents (the price of consuming housing) to earnings, and this has been
relatively stable over this period. Or to put the same point another way, the
ratio of house prices to rents has
shown a similar pattern to the ratio of house prices to incomes shown above. (The Economist has a nice resource which shows this, and covers all the
major countries besides the UK.)

If we think of housing as an asset, then the total return to
this asset if you held it forever is the weighted sum of all future rents, where
you value rents today more than rents in the future. Economists call this the
discounted sum of rents. (If you are a homeowner, it is the rent that you are
avoiding paying.) So why would house prices go up, if rents were roughly
constant and were expected to remain so? The answer is that prices would go up
if the rate at which you discounted the future fell. The relevant discount rate
here is the real interest rate on alternative assets. That interest rate has
indeed fallen over much the same time period as house prices have increased, as
Chapter 3 of the IMF’s World Economic Outlook for March 2014
documents.

Think of it this way. You believe that the return you get from
owning a house (the rent you get or save paying) will be roughly constant in
real terms. However the return you get on other assets, measured by the real
interest rate, is falling. So housing becomes more attractive as an asset. So
more people buy houses, and arbitrage
will mean its price will rise until the rate of return on housing assets adjusts down
towards the lower rate of return on other assets. As Steve Nickell pointed out in 2004, if the expected risk free
real interest rate permanently fell from, say, 4% to 2%, this could raise real
house prices by 67%.

It is the expected
return on other assets that matters here. The fact that actual real interest
rates have fallen in the past would not matter much if they were expected to
recover quickly. A key idea
behind today’s discussion of secular stagnation is that real interest rates
might stay pretty low for a long period of time. That in turn implies that
house prices will be much higher relative to incomes than they were when real
interest rates were higher.

So what appears to be a bubble may instead be a symptom of
secular stagnation. We can make the same point by looking at another measure of
affordability, again provided by Nationwide.

UK First time buyer mortgage payments as a percentage of mean disposable income: source Nationwide

First time buyers are able to afford elevated house prices,
because interest rates on mortgages are so low. Of course raising the deposit
is a problem, but the government’s Help to Buy scheme has come to the rescue by
effectively restoring the 95% mortgage that disappeared in the recession.

Secular stagnation is a global idea, so if this story is right
then we should see similar patterns abroad. Using the Economist as a guide, I think we can split
countries into three groups. The first group is the UK, France (which looks
very much like the UK!), Belgium, Italy, Sweden, Canada, Australia and New
Zealand. There the house price to income ratio rose sharply in the 2000s, and
has stayed high. The second group is the US, Denmark, Ireland, Netherlands and
Spain, which also show large increases in the 2000s, but where post-recession
declines have been so large as to actually wipe out (or come close to wiping
out) these gains. For these countries it could be a bubble, or it could be an
underlying rise temporarily offset by the impact of the recession. The third
group is Germany and Switzerland (and maybe Austria), where the ratio has been
falling over time, but has picked up over the last five years. There is one
outlier, Japan, where the ratio has been falling since 1990. In a nutshell, the
data is not clearly consistent with the secular stagnation story but does not
clearly reject it either (ever thus!)

Does this mean we should stop calling what is happening in the
UK a bubble? The first point is that secular stagnation is just an idea, and it
may prove wrong, and if it does house prices may come tumbling down. Second,
even if it is not wrong, it is still possible to have a bubble on top of the
increase implied by lower interest rates. Indeed one of the concerns about the
lower real interest rates associated with secular stagnation is that, by
raising asset prices not just in housing but elsewhere, it may encourage
bubbles to develop on top. So all we can say with certainty, for the UK at
least, is that the Financial Policy Committee will have their
work cut out when they next meet in June.

Saturday, 19 April 2014

The first half of this
post is meant for non-economists, but it ends with a couple of points on OLG
modelling

I recently wrote a post on the Eggertsson and Mehrotra paper on secular stagnation, because I thought the
paper was interesting. A much more critical post from Unlearning Economics (UE) has just
appeared in Pieria. UE says it “helps to illustrate the
troubles faced by contemporary macroeconomics”. One of UE’s complaints seems to
reflect a misunderstanding, often shared by non-economists, about what much
academic macromodelling is designed to do.

UE objects to the fact that the model assumes that the amount
the young can borrow (the degree of leverage) is exogenous, which means that
there is no attempt to explain where this constraint on the borrowing of the
young comes from. UE also complains that the model contains no banks, and no
investment in physical capital. In other words, the model is much too simple.
It is a natural enough idea: to explain what might be currently going on, you
need a more complex model that includes everything that could be important.

There is certainly a place for this kind of more elaborate
model. Christiano,
Eichenbaum and Trabandt in
this
paper want to argue that a model based on New Keynesian theory can
track what has happened over the last ten years. Their model has 40 equations.
If I was trying to do a similar exercise, I would want to augment the standard
New Keynesian framework with at least the following: nominal wage stickiness as
well as price stickiness, a financial sector that endogenised both the cost and
rationing of credit, a model of consumption which allowed for credit constraints and precautionary
saving, a housing market, a model of the labour market that combined matching with rationing (as here), and something that allowed recessions
to have long lasting (hysteretic) impacts on labour supply and technical
progress. However large models like this will involve many macroeconomic
‘mechanisms’, and it will generally be unclear which mechanisms are important
at driving particular results or explaining particular facts. We do not want to
treat the elaborate model as a black box, but instead we want to understand its
properties.

To understand complex models, we need much simpler models. (I
once - in this paper - called the process of relating complex
models to simpler models ‘theoretical deconstruction’.) In fact it is often
sensible to start with the simpler model. For example, a particular issue with
secular stagnation is to show how the natural real interest rate can be
negative for decades rather than years (i.e. beyond the Keynesian short term)?
What mechanism can do this? As I explained in my post, neither a standard
representative agent model nor a standard two period overlapping generations
model (OLG model, where the two generations are those
earning and those retired) will give you that result. What Eggertsson and
Mehrotra show is that a very simple three period OLG model (which adds a young
generation that borrows) where borrowing by the young is constrained (they
would like to borrow more but cannot) can provide just that mechanism.

That is a key point of the paper. The paper is not designed to
explain where borrowing constraints come from: there is now a big literature on
that. Thankfully the authors do not feel compelled to microfound these
constraints. Instead the paper simply offers and explores a mechanism whereby
an increase in these borrowing constraints could move the natural interest rate
into negative territory, and for it to stay there. Having established that
result, it is for subsequent work (which the authors intend to do) to see if
that mechanism survives complicating the model, by for example adding
investment.

Suppose the endeavour is successful, and a more complex but
realistic model is able to provide an account of secular stagnation that
includes other important mechanisms and which is based on a realistic set of
parameter values. That would be a success, but those not familiar with all the
work would ask: why does this model allow real interest rates to be negative
when the standard models we know do not. The reply would be that the three
period OLG structure was critical, and to see why have a look at the original, simple
model.

Now you might say the authors should wait until they have built
the more realistic model before creating what could turn out to be a research
path that might fail to achieve its goal. That would be quite wrong, because
the more debate there is within the academic community when ideas are at their
early stages the better. I want to give an example of this, but here I will go
into territory that will probably only interest macroeconomists.

It might be the case, for example, that the authors intuition
that their results will survive introducing other assets like physical capital
can be shown to be wrong very quickly. Indeed, Nick Rowe has already made such
a claim, arguing that the presence of land as an asset
ensures a positive real interest rate. If Nick was right this could be enough
to kill the research programme, without any more time being wasted. Whether he
is right is another matter: this paper by Rhee may be relevant in that respect.

Here I just want to add a final thought. Within an OLG
framework, it may not be necessary to establish the existence of a steady state
with negative real interest rates. The typical period in an OLG model lasts two
or more decades. So if the dynamics of such a model involved some overshooting,
it might be possible to generate prolonged periods (in years) of negative
interest rates even if the steady state real interest rate was positive. To be
honest I’m not sure what might give rise to overshooting of this kind, but that
may just reflect my inadequate imagination.

Thursday, 17 April 2014

For US readers, this is
about the misuse of dynamic scoring in analysing tax changes

Ask most people if they think a particular tax - like fuel duty
- should be reduced, and they will say yes. If you ask people do you think
income taxes should be raised to pay for a cut in fuel duty, you will get a
rather different response. So just asking people if they would like one
particular tax to be cut without saying how it will be paid for is pretty
meaningless. Unless of course your aim is to provide ‘evidence’ that taxes are
too high, and you are not too worried about the nature of that evidence.

There is a slightly more sophisticated version of this trick,
and the UK Treasury have just played it. Each individual tax potentially
distorts the pattern of economic activity. If that pattern without any taxes is
near some ideal, then we can call taxes ‘distortionary’. If we taxed apples and
used this money to subsidise the production of pears, people would eat too many
pears and not enough apples. However there is one tax that is not
distortionary, because it does not influence incentives and therefore this
pattern of economic activity. It is a poll tax - a tax levied on each
individual independent of their income, wealth or what they spend their money
on. Economists call this a lump sum tax. So cutting any distortionary tax, and
paying for this by raising a poll tax, is bound to produce beneficial results
in terms of reducing distortions.

There is only one problem with paying for a particular tax cut
by raising a lump sum tax - in the UK we do not have a poll tax. We did very
briefly - it was not very popular, because people care about fairness as
well as the distortionary impact of taxes. For this reason, you should not
expect to find a government department like the Treasury modelling the benefits
of cutting fuel duty by assuming it was paid for by raising a poll tax.
Unfortunately, that is exactly what has been done in a Treasury/HMRC report released this week

George Osborne is not planning to reintroduce a poll tax -
veneration of a past Conservative Prime Minister would not go that far. I think the argument the Treasury
would use to justify what they have done is simplicity. If you pay for a cut in
fuel duty by, say, raising income taxes, you have to model the impact of two
taxes on economic behaviour rather than just one. I don’t think that is a very
good excuse, but even if we think it has some validity it has a direct
implication: an individual study of this kind is meaningless on its own. It can
only be used in conjunction with other studies that look at the impact of
raising other taxes. Will Treasury officials therefore stop their masters using
the numbers from this exercise to justify cuts in fuel duty? No prizes for
guessing the answer. (They might if they could but they don’t have that degree
of influence.)

So what could have been the beginning of an intelligent
discussion of the costs and benefits of particular taxes (as in the Mirrlees
review, for example) has been turned into a simple propaganda
exercise.

Unfortunately it gets worse. Fuel duty is particularly
‘distortionary’ because its rate is high (see Chart 2.1 of the Treasury paper).
There might be a good reason for that. The tax could be high because it is
trying to offset damage that is not prevented by the market: road congestion,
pollution and of course climate change. In terms of the language of economics
it is (at least in part) a Pigouvian tax designed to offset externalities. In
that case the tax is not distortionary at all: a world without fuel tax would
not be ideal, and imposing a fuel tax gets us nearer that ideal. As Chart 3.1
from the paper indicates, these beneficial impacts of fuel duty are not
modelled by the Treasury’s CGE model. (This is why, as John McDermott notes, this kind of partial dynamic modelling
tends to be attractive to right wing outfits. Is it significant that the paper
does not actually include the words ‘climate change’, and just uses the vaguer
term environmental damage?)

So what the Treasury have done is modelled all the benefits of
cutting the tax, but ignored all the costs. If this was but one stage in a
process that would subsequently look at the cost of these externalities, and
would realistically model how these tax cuts were paid for, fine. As a stand
alone exercise, I’m afraid the Treasury study is worthless.

As Chris Giles notes in an excellent report, this is really part of a
political exercise to build the case for tax cuts. It has two unfortunate side
effects. First, it just encourages the suspicion among many that anything
coming out of the UK Treasury at the moment is worthless propaganda. Second, it
encourages those on the left who think that mainstream economics is inherently
biased. But if you saw an opinion poll that asked people if they thought a
particular tax was too high, without also asking what tax they would increase
to balance the books, you would not say that this shows opinion polls are
inherently biased. Instead you would just conclude that the person
commissioning the poll had a political agenda. You might also ask whether the
polling company should have accepted the commission.

Tuesday, 15 April 2014

In an earlier post I sketched out what I thought would be the
essential macroeconomic battleground for the forthcoming (2015) general
election.

● The Conservatives would lead on austerity and growth.
In May 2012 I suggested the line: “Austerity laid the foundation for our current growth, so we need to stick with it to ensure growth continues”, and the Chancellor has certainly followed my advice! Having linked
austerity and growth, the Conservatives will go on to claim that only they can
be trusted to deliver more austerity, and therefore continued growth.

● Labour, on the other hand, will lead on how living
standards have stagnated over the last five years, which current growth is unlikely to change before the election. Having offered the
Chancellor some spin in May 2012, in that post I thought it was only fair to offer
something to the opposition, which was this chart.

This is all nonsense of course. Osborne’s claim is Orwellian: austerity was
not necessary for achieving growth, but actually delayed it. In Labour’s case we
have no idea what lies behind the productivity collapse which is the main
factor behind the chart above, so ascribing it all to government policy is a
bit heroic. Having said that, the more the Chancellor tries to claim credit for employment growth, the more
he opens the government up to the idea that they are responsible for the
decline in living standards.

For those who are tired of this focus on traditional
macroeconomics, there may be some better news. One additional element in the
battleground to come might be the issue of inequality, but only if Labour
chooses to fight on this ground. The reason is that the Conservatives have signalled that they will reprise their
ambition to raise the exemption threshold for inheritance tax from £325,000 up to £1m.

President Obama has said that inequality is the “defining
challenge of our time”. Thomas Piketty's “Capital in the
Twenty-first Century” emphasises the importance that concentrated wealth is
likely to play in increasing this inequality if it is allowed to be transmitted
across generations. Inheritance taxes are clearly central to all that. So the
Conservative proposal to raise the inheritance tax threshold is in effect
saying that they do not regard increasing inequality as a problem.

Will Labour respond by raising the issue of inequality? They have been reluctant to do this in the past, which seems paradoxical. One of the reasons for this paradox that I speculated on here was a view that to be elected Labour has to have some backing from the business sector. This position was recently outlined by Alan Milburn (former Labour cabinet minister) in this FT article. “Labour cannot afford a rerun of the 2010 election campaign, when not a single major corporation was prepared to endorse it. Overcoming that …. will need Labour to embrace a more avowedly pro-business agenda and match it with a more overtly pro-business tone.” He goes on: “Being a “One Nation” party means governing in the interests of all sections of society, better and worse-off alike. Reintroducing a 50p higher income tax rate does not match that objective.” There we have Labour’s dilemma in a nutshell. Taking action to reduce inequality is seen as anti-business, and it is argued that Labour cannot win without some business sector support.

So I read with interest a piece by Ed Balls in the Guardian today. There he majors on the cost of living, but there is just a hint of something more: “the ongoing cost of living crisis is deeper and broader than one or two sets of figures. It's about whether most people on middle and lower incomes see their real earnings grow in line with the growth in the economy.” But inequality is not mentioned once, and fairness is only mentioned in the context of “balancing the books”.

This is hardly raising inequality as a “defining challenge of our time”. Does this reflect a genuine difference between the left on either side of the pond, or simply that Obama is in power and Ed Balls is not? If it is the latter, is Labour right to fear that going strong on inequality would lose them the election? Let me end with some encouragement from an unlikely source. A recent Financial Times leader argued that

“ratcheting up the IHT threshold to £1m cannot be justified at
present. Making this promise is good pre-election Conservative politics.
Implementing it in these austere times would be socially unjust.”

They make a number of important points. Even if thresholds
remain unchanged, and despite high house prices, the OBR estimate that just 10%
of estates will be liable to pay any tax at all. Implementing the £1 million
threshold would cost the Treasury more than £3bn, which in times of austerity
is money that could be better used elsewhere. And finally they say that redistribution
is vital if inequality is not to be exacerbated. When the FT starts worrying
about inequality, perhaps this is after all a battle that Labour can win.

Monday, 14 April 2014

There has been some comment on the decision of the US central
bank (the Fed) to publish its main econometric model in full. In
terms of openness I agree with Tony Yates that this is a great move, and that
the Bank of England should follow. The Bank publishes some details of its model
(somewhat belatedly, as I noted here), but as Tony argues this falls some way short of what is
now provided by the Fed.

However I think Noah Smith makes the most interesting point: unlike the
Bank's model, the model published by the Fed is not a DSGE model. Instead, it is what is often
called a Structural Econometric Model (SEM): a pretty ad hoc mixture of theory
and econometric estimation that would not please either a macro theorist or a
time series econometrician. As Noah notes, they use this model for forecasting and policy analysis. Noah speculates
that the Fed’s move to publish a model of this kind indicates that they are
perhaps less embarrassed about using a SEM than they once were. I’ve no idea if
this is true, but for most academic macroeconomists it raises a puzzling
question - why are they still using this type of model? If the Bank of England
can use a DSGE model as their core model, why doesn’t the Fed?

I have discussed the question of what type of model a central
bank should use before. In addition, I have written many posts
(most recently here) advocating the advantages of augmenting
DSGE models and VARs with this kind of middle way approach. For various
reasons, this middle way approach will be particularly attractive to a policy
making organisation like a central bank, but I also think that a SEM can play a
role in academic analysis. For the moment, though, let me just focus on policy
analysis by policy makers.

Consider a particular question: what is the impact of a
temporary cut in income taxes? What kind of methods should an economist employ
to answer this question? We could estimate reduced
forms/VARs relating variables of interest (output,
inflation etc) to changes in income taxes in the past. However there are
serious problems with this approach. The most obvious is that the impact of
past changes in taxes will depend on the reaction of monetary policy at the
time, and whether monetary policy will act in a similar way today. Results will
also depend on how permanent past changes in taxes were expected to be. I would
not want to suggest that these issues make reduced form estimation a waste of
time, but they do indicate how difficult it will be to get a good answer using
this approach. Similar problems arise if we relate growth to debt, money to
prices (a personal reflection here) and so on. Macro reduced form analysis
relating policy variables to outcomes is very fragile.

An alternative would be for the economist to build a DSGE
model, and simulate that. This has a number of advantages over the reduced form
estimation approach. The nature of the experiment can be precisely controlled:
the fact that the tax cut is temporary, how it is financed, what monetary
policy is doing etc. But any answer is only going to be as good as the model
used to obtain it. A prerequisite for a DSGE model is that all relationships
have to be microfounded in an internally consistent way, and there should be
nothing ad hoc in the model. In practice that can preclude including things
that we suspect are important, but that we do not know exactly how to model in
a microfounded manner. We model what we can microfound, not what we can see.

A specific example that is likely to be critical to the impact
of a temporary income tax cut is how the consumption function treats income
discounting. If future income is discounted at the rate of interest, we get
Ricardian Equivalence. Yet this same theory tells us that the marginal
propensity to consume (mpc) out of windfall gains in income is very small, and
yet there is a great deal of evidence to suggest the mpc lies somewhere around
a third or more. (Here is a post discussing one study from today’s Mark
Thoma links.) DSGE models can try and capture this by assuming a proportion of
‘income constrained’ consumers, but is that all that is going on? Another
explanation is that unconstrained consumers discount future labour income at a
much greater rate than the rate of interest. This could be because of income
uncertainty and precautionary savings, but these are difficult to microfound, so DSGE models
typically ignore this.

The Fed model does not. To quote: “future labor and transfer
income is discounted at a rate substantially higher than the discount rate on
future income from non-human wealth, reflecting uninsurable individual income
risk.” My own SEM that I built 20+ years ago, Compact, did something similar. My colleague, John Muellbauer, has persistently pursued
estimating consumption functions that use an eclectic mix of data and theory,
and as a result has been incorporating the impact of financial frictions in his
work long before it became fashionable.

So I suspect the Fed uses a SEM rather than a DSGE model not
because they are old fashioned and out of date, but because they find it more
useful. (Actually this is a little more than a suspicion.) Now that does not
mean that academics should be using models of this type, but it should at least
give pause to those academics who continue to suggest that SEMs are a thing of
the past.

Sunday, 13 April 2014

For macroeconomists. This
post is a kind of introduction to the new paper on secular stagnation by Eggertsson and
Mehrotra. As usual, any misinterpretations are my fault.

A basic idea behind secular stagnation is that the natural real
rate of interest might become negative for a prolonged period of time. A simple
way to model this would be to allow the steady state real interest rate to
become negative. That cannot happen in basic representative agent models, where
the steady state real interest rate (absent growth) is given by

1+r = 1/b

where b<1
is the utility discount factor. With population growth (at rate = n) this
becomes

1+r = n +1/b

Note that a fall in n will reduce the real interest rate, which
is a useful result if we want to relate secular stagnation to falling
population growth, but rates cannot fall below the rate of time preference.

In a standard two period OLG model we have more flexibility. If
agents only work in the first period, then they need to save in that period to
be able to smooth consumption between their working lives and retirement. If we
allow them to do that through investing in capital, and if α is the exponent on
capital in a Cobb Douglas production function, then with log utility the real
interest rate in steady state is given by

r = k + kn where k
= α(1+b)/b(1- α)

If one period is about 25 years, then b could be 0.5 (annual b = 0.973),
and with α = 0.4 then k=2. So now the impact of a fall on population growth on
the real interest rate is magnified, but the steady state real interest rate is
also likely to be above the representative agent case. (If n=0 and b =
0.5, then we have r=1 and r=2 respectively. For a 25 year period this would
correspond to annual interest rates of around 2.8% and 4.5%.)

In a three period OLG setup, we can have saving without
capital. The middle aged work (receiving income Y), and they lend to the young,
and in retirement get paid back by the now middle aged. Suppose, however, that because
of some credit friction the amount the young can borrow gross of interest payments is fixed at D, and let d=D/Y<1. The
middle aged would like to lend them enough to smooth consumption, so the supply
of loans in steady state is (given log utility)

b (Y-D)/
(1+b)

where Y-D is middle age income net of repaying loans taken out
when young. The demand for loans is

D (1+n)/(1+r)

The borrowing limit is gross of interest, so with no population
growth actual borrowing is D/(1+r). With population growth there are more of
the young than middle aged, so we need to scale up loan demand accordingly. The
real interest rate equates demand and supply, which implies

1+r = j + jn where j
= (1+b)d/b(1-d)

Now if d is small, j could be less than one, which reduces the
sensitivity of interest rates to population growth, although a fall in population growth still reduces rates. However this also means
that the gross interest rate (1+r) could be less than one, so the steady state
real interest rate could be negative.

The middle aged need to save for retirement, but the only way
they can do this is by lending to the young. The higher the real interest rate,
the less the young can borrow because of the credit friction. In that situation,
the real interest rate could easily be negative, because only then will the
young be able to borrow enough to allow the middle age to consumption smooth
when they retire.

The key result that Eggertsson and Mehrotra explore is that a
credit crunch - a fall in D - could lower real interest rates into negative
territory, and could therefore generate secular stagnation. They consider how
inequality could be incorporated into the model, and then embed the model in a
nominal framework. Nominal wage rigidity is added (using a similar mechanism to
that in the Schmitt-Grohe and Uribe paper I discussed here), and the implications for monetary and
fiscal policy explored. So I have only touched on the paper here, but as this three period OLG set-up is not standard I thought this post might be
useful.

Saturday, 12 April 2014

If a bank is too important to fail (TITF), it in effect gets a
subsidy from the public. That subsidy is like an insurance contract for those
who lend to these banks: if the bank looks like it will fail, it will be bailed
out by the government and depositors will get their money back. This in turn
means that TITF banks can borrow more cheaply, so they get the benefit of this
subsidy every year. TITF banks could do various things with this subsidy: they
could make their loans to firms or consumers cheaper (thereby undercutting
competition from smaller banks), they could make higher profits that go to
either shareholders or as bonuses to bankers themselves, or they could take
excessive risks. They will probably do some combination of all of them.

In 2009 the Bank of England calculated the value of this
subsidy at £109 billion: that is about £1750 for each person in the UK. The
TITF banks of course dispute this figure. (Donald MacKenzie has a very readable
account of one example in the London Review of
Books.) A week ago the IMF published their own study (pdf), using two different market based methods
to measure this subsidy. (The IMF chapter is very readable, but Simon Johnson
also has a good summary here.) This is a very imprecise science, but
the IMF confirm that subsidies to TIMF banks are very large, although the £109
billion figure quoted above is probably at the upper end of the range of
estimates (as the Bank also acknowledged in a later study). However, if we
described this number as each member of the public’s contribution to help pay
bankers bonuses (which it could well be), I think everyone would agree even a more
modest figure is unacceptable.

There are two particularly interesting features of the IMF
analysis: it calculates numbers across countries and across time. On the first,
some might have assumed that TITF subsidies would be largest in the US, but
this is not the case. In dollar terms subsidies in the UK and Japan are of a
similar size to the US, and of course the UK is a smaller country, so per
capita subsidies are larger in the UK. In dollar terms subsidies appear largest
in the Euro area. The IMF also calculate subsidies before the crisis (2006-7),
during the crisis (2008-10) and after the crisis (2011-12). The worrying aspect
of these calculations is that the subsidies do not seem to have fallen
substantially in the post crisis period compared to pre-crisis.

Worrying, but hardly surprising. In principle the TITF problem
is fairly easy to solve: as Admati and Hellwig convincingly argue
the proportion of the bank’s balance sheet that is backed by equity should be
much much higher. (In simple terms, if a bank gets into trouble there are many
more shareholders able to absorb losses before a government bailout is
required.) The problem of TITF banks is political. As I discussed here, the lobbying power of the TITF banks is
enormous. This is not just a matter of bribing campaign contributions to
politicians. In the UK there is some evidence that the depth of the recession
is partly down to lack of lending by banks, and the bank’s response to any
proposals to tighten regulation is to imply that this will ‘force’ them to lend
even less. If it is suggested that additional capital could come from reducing
bank bonuses, they say all the talent will migrate to overseas banks. Quite
simply, the TITF banks have immense power. Until the political will to take on
the banks is found, we will each continue to subsidise bank bonuses.

And there will be further financial crises. For those in the UK who think the Vickers Commission put this problem to bed [1], it is essential to read this article by one of its members, Martin Wolf. In reviewing the Admati and Hellwig book, he writes: “Once you have [understood the economics], you will also appreciate that we have failed to remove the causes of the crisis. Further such crises will come.”

[1] Because the IMF
study tracks estimates of the subsidy to TITF banks through time, it can look
at how the subsidy changed when the Vickers report was published (Table 3.2 and
Figure 3.8). Publication is associated with a significant fall in the subsidy,
but it was not nearly enough to eliminate it.